Investment Strategy:  Fourth Quarter 2021Tapering not tantruming

As we move out of the initial recovery phase from the pandemic, the great challenge for central banks will be to maintain investor confidence, while reducing their support for the economy. This will initially be done through slowing their bond buying programmes and reducing their balance sheets in order to wean the market off monetary stimulus and then to consider the beginnings of an interest rate rising cycle. Any mention of such an attempt to taper the level of support usually triggers some cautionary reference to 2013 when the then Fed Chair Ben Bernanke triggered a market sell off and a ‘taper tantrum’ as he spoke about gradually weaning the economy from the policy support that was put in place in response to the financial crisis.

Today, the primary weapon to negate a repeated tantrum is for central banks to follow the mantra of “being forewarned is forearmed” and help deliver a well-flagged, ‘no surprises’ roadmap for tapering bond purchases. The intention is for central banks to shine a bright light on the pathway that sees us through the tapering process and ultimately to policy tightening, ensuring markets do not stumble on any unanticipated events along the way. But experience colours judgement and that is the same for the people walking the halls of the US Treasury, the Bank of England or the ECB and tapering presents a double-edged sword. Taper too soon and the risk is a recovery gets moved off track; too late and you may miss your chance to raise rates, thereby weakening your potential policy response whenever the next crisis demands.

Questionable QE

There is a valid question to be answered about the level of continued monetary policy support being used by central banks, in particular the US Federal Reserve. In an economy such as the US which is demonstrating higher and more persistent inflation and also one that is creating plentiful jobs, it’s a reasonable conclusion to reach to say QE has done its job and that its winding down process should be further ahead than where it is. There is also a case for speedier tapering, as continuing to try and stimulate demand in an economy showing supply side problems looks like it’s compounding a problem, rather than helping to provide the solution. 

The reason why the Federal Reserve is anxious about withdrawing stimulus remains in the level of unemployment and indicates how far the focus of the central bank has shifted in placing greater emphasis on its full employment mandate at the expense of its inflation mandate. Stung by its response to the financial crisis, Fed members and the US Treasury are seeking a more equal recovery rather than just a recovery in headline numbers alone. Its flexible average inflation target encourages it to look through temporary periods of inflation and with still over 8 million Americans unemployed and an unemployment rate over 5%, in comparison to 5.7 million unemployed and a rate of 3.5% before the pandemic (Feb 2020), the job numbers remain the greater focus.

Introduced as an unconventional tool as part of the extraordinary policy response triggered by the global financial crisis, QE has shown itself to be an effective tool at moments of crisis, ensuring businesses have access to credit lines and smoothing the workings of the banking system to help support jobs. Outside of those extremes, the efficacy of QE is more questionable. Whilst QE was initially considered an unconventional tool, it has evolved into a conventional part of the policy response tool kit central banks have at their disposal and will continue to do so. There will continue to be merit for its employment in periods of economic stress and weakness, but it also needs a carefully timed exit as part of the process of unwinding policy support and rebuilding a policy tool kit in preparation for the next economic crisis. Currently, with inflation looking elevated and with over 10 million job openings outstanding and waiting to be filled, timing a perfect exit is less important than getting the exit strategy underway.

We’re not tapering, we’re tinkering

At its most recent meeting in September the Federal Open Market Committee confirmed that a moderation in its bond purchase programme was warranted. In the subsequent press conference, Jerome Powell pointed to a mid-2022 end point for the tapering process to complete, slightly faster than anticipated. The ECB and Bank of England already had a set timeline for ceasing asset purchases. In response to the economic shock caused by the pandemic, during 2020 the Bank of England announced it was increasing the amount of its asset purchases by £450bn to a total target of £895bn to be completed by the end of 2021. Similarly, the ECB’s Pandemic Emergency Purchase Programme (PEPP) is due to end by the end of March 2022 and the pace of purchases is set to slow into the final quarter of this year to fill the allotted timeframe. As much as Christine Lagarde stressed that the ECB wasn’t tapering, but “recalibrating”, and as much as the Bank of England stressed during the early summer that is wasn’t tapering but just slowing its programme, the inevitability of fewer monthly bond purchases means both schemes are slowing down to their conclusion.

Beginning the process of tapering is not the same as tightening interest rate policy but it is the first step in beginning to normalise the extraordinary monetary policy response to the pandemic. What is clear is that the coming quarters are going to see three major central banks begin to step off the accelerator and slow, then cease, their bond buying programmes. This heightens the capacity for market volatility and whilst this is unlikely to be on a scale similar to 2013, it may well cause some bumps along the way. Central banks have been at pains to shine a light on the path they intend to follow and what this means is we are likely to be seeing steadily rising yields through the final quarter of this year. 

There remains a balancing act for central banks to navigate in beginning the process of withdrawing stimulus and reducing their balance sheets whilst maintaining investor confidence. To do this we can expect no sudden moves, but instead a well-flagged pathway to enable central banks to place QE back in its scabbard and secure it safely back in the central bank armoury to fight future battles, whenever that may be.

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